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Will emerging markets be the new leader?

L'AGEFI - As we get closer to the end of 2016 it may indeed be a good time to review 2017 earnings expectations for emerging markets (EM).

Based on consensus estimates published on Bloomberg, EM will have the strongest earnings growth in 2017 with 14% compared to 12%, 13% and 7% in the US, the EU and Japan respectively. Within EM, the strongest growth is expected in the EMEA region with 16%, followed by Latin America at 15% and Asia at 13%.

At first glance, EM’s 2017E earnings growth of 14% may seem to be something of a deceleration compared with what happened in 2016. However, an important point to note is that all of 2016's EM earnings growth came from 2015's loss making companies turning out profits once again. In fact, excluding this effect and looking only at companies with positive earnings, 2016 was the third year in a row since 2013 when net profits actually declined. 2017 will be the first year since 2013 where there is a real expectation of earnings growth using this measure.

At an individual country level, there are significant differences within EM for 2017 earnings growth expectations. For example, among the larger countries, the strongest earnings growth is forecast to be in South Africa, India and Mexico with 25%, 22% and 20% respectively while only single digit earnings growth is anticipated in Malaysia, Philippines and Thailand. In between these two groups lie China, Brazil and Russia where earnings are projected to grow by around 13-15%.

In terms of sectors, the strongest earnings growth in EM is expected in energy (27%), industrials (22%), IT (21%) and healthcare (20%). These are closely followed by consumer discretionary, staples and telecom services with earnings growth expectations of around 18%. The forecast outcomes are at their most pessimistic for materials, utilities and financials where earnings are expected to grow only by 2%, 1%, and 8% respectively.

Clearly, these projections will face significant revision over the next several months as the new US administration begins to clarify its economic priorities. It will take some time for the implementation of these policies to happen and even longer for analysts to revise earnings expectations. As of the time of writing there are still far too many uncertainties around the new direction of US economic policy. However, it is still possible to discuss some of the upside and downside risks to earnings expectations based on what is already known.

One clear promise of the Trump campaign was a boost to infrastructure investment financed by fiscal expansion. That is likely to present an upside risk to earnings expectations for the materials sector and commodity producers like Brazil, South Africa and Russia. One notable negative particularly related to Russia is oil whose price faces a possible negative impact from Trump’s plans to increase US shale production. For the same reason, the energy sector in EM could see earnings downgrades.

Another clear message of the Trump campaign was the call for controls on immigration and international trade. There is a wide range of policy options here starting from relatively light and low cost measures like naming trading partners as currency manipulators, to difficult and costly changes like implementing across the board import tariffs. Each of these measures could impact earnings negatively in varying degrees. While it is impossible to make a prediction at present, the most obvious countries facing the risk of earnings downgrades are Mexico, South Korea and Taiwan, while large countries with relatively little export dependency like India, Brazil and Indonesia would be relatively less affected.

The scope and severity of trade restrictions are likely to be limited by the fact that any trade restriction also has a cost for US consumers and corporates. This raises the danger of adopting an overly-pessimistic view of EM exporters based on unrealistic scenarios. It is important to remember that over the last several years intra EM trade has expanded and the region as a whole is less dependent on trade with the US. Ongoing rebalancing of the Chinese economy with a strong growth of services and consumption could help to alleviate any potential negative shock from US actions.

The interest rate environment could well be another factor weighing on EM countries. An extended period of fiscal expansion in the US could lead to higher rates which would negatively affect earnings growth in countries dependent on external funding. The two names that stand out with large current account deficits are Turkey and South Africa.

Finally, exchange rates are also likely to play an important role in any potential earnings revisions. During the week following the election, the JP Morgan EM currency index lost more than 4% of its value against the USD. Beyond this headline number there is a wide range within EM countries depending on perceived currency vulnerability. For obvious reasons the Mexican peso was the worst effected, losing 12% of its value against the USD during the same period. The peso was followed by the Brazilian real and the South African rand, two high yielding currencies favoured by carry traders before the elections, which lost more than 8% of their value. In these countries we are likely to see downward earnings revisions for those companies with high levels of FX debt or large import costs whereas there could be upward revisions for exporters. At the other end of the spectrum are countries like India and China where the currency move was not significant.

One important difference between this potential USD strength versus previous crisis periods in EM like 1994 and 1997 is that unlike those times most currencies are now free floating and adjust quickly to changes like the current cases of Mexico, Brazil and South Africa. The weakness in these currencies has already made those countries more competitive and has partly offset the cost of a potential increase in tariffs.

In summary, even though the earnings picture of 2017 is somewhat uncertain at the moment, the earnings recovery that started in EM in 2016 is likely to continue in 2017. A key assumption behind this view is that any US restrictions on trade are likely to be limited in scope due to their potential negative impact on US corporates and consumers, while the new administration is likely to go ahead with a significant fiscal expansion plan. This may lead to intra-EM and intra-sector shifts in earnings away from countries and corporates dependent on exports to the US and high FX debt towards companies benefiting from higher commodity prices, cheap currency, low debt and growing domestic consumption. EM equities as an asset class will continue to present an attractive exposure to the likely reflation trade and to EM’s domestic demographic strength.

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